Pips, Lots, Margin and Leverage – basics to make real pips

Learn pips before making them

You will be absolutely dumbfounded if you knew how many traders are oblivious to terms like margin, leverage, lot size and even pips. Let alone calculating them, some don’t even know how these faculties affect a trading account. I know, it can be daunting when you first hear these words and their definitions. But, there is no way one could develop a sustainable portfolio or a trading career without properly understanding the underlying concepts of these terms.

First things first…

What are Pips?

For instruments that has 4 digit prices, a pip is the 4th decimal price unit of the instrument. For instruments that has 2 digit prices a pip would be 2nd decimal price unit. So by default the value of a pip is measured in the base currency. e.g. for EURUSD the nominal change of a pip is 0.0001 USD and for USDJPY the change of a pip would be 0.01 JPY. But in both cases, its only one Pip in terms of units.

What about 5 and 3 digit prices, you may ask. Well, the final decimal price unit in case of a 5-digit or 3-digit price is called 1 Point (also as a Pippette.) So 10 Pippettes/points = 1 Pip. While this is the standard terminology which I learnt a long while ago, there are professional traders who call Pips as Points and vice versa. There is nothing wrong with it, as long as all parties involved in the conversation understand both the term and the context.

e.g. If a trading journal mentions x.thousands of Pips in a week, when in reality it means x.thousands of points not pips, I personally consider it as misleading information.

Lot size

1 Standard Lot is equal to 100,000 units. e.g. for GBPUSD it is £100,000 worth and for USDJPY it is $100,000 worth. It’s best not to attach the currency denomination to the lot size, because it can quickly get confusing. Specially if the instrument doesn’t contain the account currency.

There are few more smaller lot sizes:

Mini lot : 10000 units
Micro lot: 1000 units
Nano lot: 100 units

Example pip value calculation in USD for 1 standard lot:

Here is an easy method to understand the pip value with an example of GBPUSD 1 Standard Lot @ 1.3000. The 4th decimal point is 1 pip. So the price 1.3000 has 13000 pips in it.

The point is if someone says 1 pip equals to $10 for a standard lot, it does not make sense whatsoever, unless the context is GBPUSD as per the above examples. You must remember that the value of a pip varies depending on the instrument and its current price.

What is Leverage and Margin?

There is no better way to explain Leverage and Margin than use a realistic example.

Let’s say you want to buy a house worth $100,000 and resell it for profit after sometime. But you don’t have the total capital required but only $2,000. So you go to your bank and ask for funding in order to purchase the house (for the sake of simplicity, don’t confuse this example with mortgage and stuff.) Now the bank says ok, and asks you to open a margin account with $2,000 and keep, let’s say $1000 as a good faith deposit called the “margin” for the transaction. Then the bank lends the rest of $100,000. The $1000 will be locked in the account as margin until you liquidate the house. Interesting right?

Furthermore, the bank does not want anything to do with the profit/loss when you liquidate the house and asks only for a nominal fee for the services (let’s say $100 for the sake of this example.) Of course any profit or loss when liquidated, will be adjusted to the remaining $900($1000 – $100 fee) in your account. Which brings us to the fact that the maximum possible drawdown during this trade would be $1900 (assuming the margin call level is set at 0% and disregarding the government regulations regarding minimum margin call percentages.) In other words, the bank never loses money due to a stale investment made using leveraged capital. Remember, profit or loss always goes with the trader.

Now replace the house with a standard lot of a forex instrument. This is how margin works.

Leverage and Margin call

What about leverage? You have already grasped the concept of leverage in the same example above. When you agreed for $1000 as margin to operate a $100,000 transaction, effectively you had used 100x leverage of the margin. In standard forex terminology leverage of 1:100. Maximum available leverage depends on the forex broker. Maximum leverage amounts between 1:50 and 1:400 are more common numbers in retail forex.

Now is a good time to understand “Margin call” as well. Suppose the value of the house drops to $98,100 (assuming that exact market valuation of real estate is possible,) then you would get what’s referred to as a “Margin call.” It simply means that your account liquidity is 0 and requires more funding to absorb the drawdown and hold onto the position. Any lower price-quote would liquidate the position and your account will be terminated. This is often the result of using the dreaded combination – small capital, high leverage and oversize positions.

Choosing the right leverage entirely depends on several aspects e.g. account size, position sizing, trading strategy and also your risk appetite. There is no one size fits all leverage ratios.

Last note

These are just basic terms and concepts in forex, I am certain that you already knew them. But the important thing is to have a proper understanding of the fundamental stuff that can make or break your success as a trader. It does not matter if you have a 100% winning strategy. Even such perfect strategy cannot make you money unless you know the basic stuff like margin, leverage, lot size and pips value.

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Disclaimer

READ THIS BEFORE YOU INVEST IN TRADING: Forex trading carries a high level of risk and you should only trade with money you can afford to lose. You can lose your capital and more. Please understand and apply risk and capital management, more importantly familiarize yourself with the risks involved in this business.
NFA and CTFC Required Disclaimers: Trading in the Foreign Exchange market is a challenging opportunity where above average returns are available for educated and experienced investors who are willing to take above average risk.[Read More]